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Is the Fed Finding Its Footing?

So the Federal Reserve met the markets’ expectations and raised its target interest rate by 0.25% today. (Interestingly, Wall St immediately jumped higher as the news broke right along with gold prices.) But what direction will the Fed ultimately go over the next two years?

Before we dive into the rate hike, here’s a quick video explaining why the fed funds rate is so important.

What criteria will the central bank use for determining its future policy moves? Today’s FOMC statement—as expected—provided little clarity on this crucial question.

Economic data of late has been relatively strong, which no doubt bolstered the Fed’s resolve in hiking rates for the second time in four months. Friday’s nonfarm payrolls (NFP) report was hyped up as one such key data point that informed the Fed’s decision. The NFP came in above expectations.

Inflation

This turn toward a more hawkish outlook by the Fed follows two years of ultra-low interest rates. Over that time, the central bank was relatively inconsistent in how it characterized the labor market. Even after unemployment dwindled below the Fed’s target for “full employment,” it continued to support near-zero interest rates by modifying its guidelines. The headline unemployment rate may have fallen well below 5%, but the central bank still sees slack in the labor market—meaning employers still have the capacity to hire more workers. Wages have also finally been rising. Still, rates have hardly budged from the zero lower bound. This has prompted many analysts to accuse the central bank of being “behind the curve” and waiting too long to raise rates.

The Fed has admitted it is inclined to allow inflation to overshoot slightly to the high end rather than putting the brakes on an accelerating economy. However, this could backfire badly—especially given certain problems with how inflation is understood in the first place.

The two mandates for the Federal Reserve are full employment, which the economy has currently reached or is very near, and stable prices (i.e. a 2% annual inflation target). This means that the way the Fed thinks about, talks about, and approaches inflation is key to its policy considerations.

Research into the nature of inflation and economic growth reveals that the Fed’s favorite indicator of inflation actually isn’t nearly as predictive as economists’ models suggest. Surprisingly, inflation expectations don’t bear a strong correlation to actual future inflation. In fact, expectations trail real-life changes in inflation, telling us nothing about what to expect. Predicting future inflation is a crucial part of the Fed’s job, yet it may be misinterpreting its own tools for doing so (or using faulty tools).

These conclusions were reached by a group of economists writing for the statistics-oriented news site FiveThirtyEight:

“We conclude that the Fed needs to remain vigilant. Movements in slack and inflation expectations can be misleading, so policymakers should closely monitor a broader set of indicators. While a modest overshoot may be appropriate, if inflation continues rising, policymakers will need to act. Allowing inflation to rise too much could lead to a prolonged period of inflation above 2 percent. If that happens, the Fed could be forced to aggressively raise interest rates to bring inflation under control.”